The SEC’s Cybersecurity Guidelines: A Potential Game-Changer for How Companies Disclose Risks of Cybersecurity Breaches

A cybersecurity breach can create huge costs for a corporation by damaging the company’s reputation and consumer loyalty while also creating the risk of class-action litigation. The Securities and Exchange Commission (SEC) has recognized the risks that publicly traded companies face in dealing with cybersecurity incidents. In October 2011, the SEC promulgated guidelines that publicly traded companies should evaluate when determining what information should be disclosed concerning a cybersecurity incident or potential incident. These advisory guidelines provide a new paradigm for evaluating how cybersecurity risks should be disclosed by publicly traded companies.

While the guidelines are not a rule, regulation or statement of the SEC, and while the commission has not approved or disapproved of its content, publicly traded companies need to be aware of the guidelines and plan accordingly. By promulgating the guidelines, the SEC has made the financial community aware that it considers cybersecurity a very serious matter and that the impact of cybersecurity on a company’s bottom line should be disclosed. Simply ignoring the impact that a cybersecurity incident may have on a company’s balance sheet is no longer a proper course of action.

Evaluate the Risks of Cyber Incidents

The guidelines instruct companies to disclose the risk of cyber incidents if a security incident may be “among the most significant factors that make an investment in the company speculative or risky.” In making this determination, a company should examine its cybersecurity risks, prior cyber incidents and the severity and frequency of such incidents. A company should also analyze the likelihood of additional incidents occurring in the future and the impact of such incidents on the company. A company does not need to disclose risks that would typically be generic in nature.

If a company determines that disclosure of the risk of a cyber incident is appropriate, the SEC instructs that appropriate disclosures may include discussion of aspects of a company’s operations that give risk to material risks; outsourced security functions; past cybersecurity incidents and costs of remediating the incidents; risks of undetected cybersecurity incidents, and relevant insurance coverage that might cover the incident.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The SEC instructs that a company should address cybersecurity risks and incidents in their MD&A “if the costs or other consequences associated with one or more known incidents or the risks of potential incidents represent a material event, trend or uncertainty that is reasonably likely to have a material effect” on the company’s financial position. For example, if critical intellectual property is stolen, a company may want to consider disclosing that the information was stolen and the effect of the theft on the company’s position.

Legal Proceedings

The SEC instructs that a legal proceeding involving a cyber incident may need to be disclosed. This would be disclosed in the company’s “Legal Proceedings” disclosure. The disclosure would state the name of the court, the date the suit was instituted, the principal parties, a description of the allegations and the damages sought.

Dealing with a Cyber Incident

A cybersecurity incident will likely require disclosure of certain losses. If a cybersecurity incident affects a publicly traded company, the company might consider providing an incentive to customers in order to retain the business. Such incentives should be appropriately disclosed. In addition, a cybersecurity breach may create losses related to warranties, breach of contract, indemnification of counterparty losses, diminished future cash flows and impairment of good will and intangible assets. Companies should provide disclosure of such losses as well.

Three Steps Companies Should Take

Given the new SEC advisory guidelines, publicly traded companies should make sure that they are adequately protected in the event of a cybersecurity incident or potential incident. They can do so by taking the following three steps:

Evaluate the likelihood of a potential cybersecurity incident and examine their existing disclosures to determine if they are meeting their obligations under the SEC guidelines.

If a company handles sensitive types of data—like financial data or healthcare information—the company should seriously consider updating its disclosure forms to explain the impact of a cybersecurity incident on the bottom line. Such an incident would likely result in significant remediation measures, litigation or fines imposed by a regulatory body.

Many insurance companies require the purchase of cyber risk insurance to cover a cybersecurity breach. The SEC’s emphasis on insurance as a way to mitigate risk means that companies should evaluate their insurance policies in light of the risk of a security incident.

While the SEC guidelines are merely advisory in nature, new legislation has been proposed that would require certification requirements by certain entities on cybersecurity readiness.

The SEC’s guidelines address cybersecurity incidents in the context of business planning and risk management. By emphasizing risk factors and disclosure obligations, the SEC guidelines demonstrate that managing information security is about risk analysis rather than a particular type of technology at issue.

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